Financial Reporting Concerns, Framing Effects and Employee Stock Option Grants
54 Pages Posted: 15 Sep 2006
Date Written: September 15, 2006
Managers are concerned about reported earnings (e.g., Graham et al. 2005). The favorable accounting treatment for employee stock options (ESO) available under the pre-expensing regime lead managers to frame ESOs as cheap to grant (e.g., Murphy 2002 2003; Hall and Murphy 2003; Jensen and Murphy 2004). This paper tests two effects of framing in the context of employee stock option grants: the reference-point-dependent preferences and the ratio-difference principle. I analyze stock option grants to CEOs, the other top 4 executives, and non-executive employees in 859 firms from 1996 to 2002. I find that firms grant more stock options when doing so helps them to meet or beat earnings targets, consistent with the notion of reference-point-dependent preferences in prospect theory. Further, I analyze the relationship between the extent of potential "expense saving" and stock option grants. I find that firms grant more options when granting stock options have a bigger impact on reported earnings, consistent with the ratio-difference principle in mental accounting theory. In sum, results suggest that management decision making of ESO grant is subject to framing effects.
Keywords: financial reporting concerns, framing effects, prospect theory, mental accounting, ratio-difference principle, employee stock options, executive compensation, FAS 123R
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